Credit Connect

New IFS research, funded by the Nuffield Foundation, looks at recessions, inequality, and the role of the tax and benefit system. It finds that planned benefit cuts will leave low-income households more exposed to the impact of future recessions.

If falls in the earnings of workers seen between 2007–08 and 2011–12 happened again now, the poorest 30% of working-age households would see their after-tax incomes fall by an average of only 39p for every £1 fall in pre-tax earnings. This is because of the offsetting impact of lower direct taxes and higher benefits. But when benefit cuts currently being rolled out are fully in place, that figure rises to 53p for every £1. Some working households currently receiving in-work benefits will no longer be entitled, and so won’t see their benefits rise as soon as their earnings fall. Some of those who are still entitled will see benefits rise less when earnings fall.

The Office for Budget Responsibility puts the chances of a recession in any five-year period at 50:50. Economic uncertainty is currently high. When the next recession does hit, the tax and benefit system will offer less support to low-income households.

The government is in the process of implementing a number of significant cuts to means-tested working-age benefits. The biggest are a cash freeze in most working-age benefits, cuts to child tax credit, and the introduction of the less generous universal credit. These cuts make low-income households worse off, while reducing benefit spending and, potentially, strengthening work incentives. But another part of this story is that these benefit cuts mean the government will, by default, provide less insurance to households in the event that their earnings fall.

Other key findings include:

In-work benefits for low-income households were a key reason inequality fell during the Great Recession. Absent any changes to the tax and benefit system, the net incomes of the lowest-income working households would have fallen by less than 5% between 2007–08 and 2011–12, despite falls in household pre-tax earnings of more than 10%. In fact, the incomes of the lowest-income households actually rose, thanks to increases in the generosity of some benefits (most significantly, child tax credit).

The differences in the impact of past recessions on inequality are largely explained by differences in the labour market impacts:the big rise in unemployment during the early 1980s increased inequality, while the sharp falls in earnings during the Great Recession acted to reduce inequality.

If hit by a recession whose effects were concentrated on employment rather than pay – as was typical until the last recession – the current and planned future tax and benefit system would provide less insurance to households on average than systems we had in the past. If the employment falls seen in the early 1980s reoccurred today, 55% of the total impact on pre-tax earnings would be passed through to net household incomes (with 45% borne by the public finances through lower taxes and higher benefits). Under the tax and benefit system in place back then, the split would be 50:50. The main explanation is that out-of-work benefits are a smaller fraction of earnings than they were back then.

Andrew Hood, a Senior Research Economist at IFS and an author of the report, said “When governments change the tax and benefit system they should consider the impact on the support the system will provide to households when the next recession hits. Planned cuts to working-age benefits will leave low-income households with children in particular more exposed to any future downturn in the labour market, by reducing the extent to which earnings losses would be offset by increased entitlement to benefits. This is particularly important since many in this group have little or no savings which they can draw on during a period of temporary difficulty.”